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Exchange Rates and the Foreign Exchange Market

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The exchange rate between two currencies is the price of one currency in terms of the other. ... foreign exchange market occurs when returns on deposits in ... – PowerPoint PPT presentation

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Title: Exchange Rates and the Foreign Exchange Market


1
Exchange Rates and the Foreign Exchange Market
  • Roberto Chang
  • Econ 336
  • March 2007

2
Plan
  • Main reference chapter 13 of KO
  • Exchange Rates definitions, appreciation and
    depreciation.
  • The Foreign Exchange Market actors, contracts.
  • The concept of rate of return on domestic and
    foreign currency assets.
  • Interest rate parity a first approach to
    exchange rate determination.

3
Exchange Rates definition
  • The exchange rate between two currencies is the
    price of one currency in terms of the other.
  • Example 1 Euro 1.30 US dollars ? The exchange
    rate is 1.30 dollars per Euro, or 1/1.30 Euros
    per dollar.

4
  • The exchange rate allows us to translate prices
    in, say, Euro to dollar prices.
  • If the price of the dollar in terms of Euros
    falls, we say that the dollar depreciates and the
    Euro appreciates
  • If the dollar depreciates, goods whose prices are
    given in Euros become more expensive in dollars.

5
The Foreign Exchange Marketthe Actors
  • Commercial Banks
  • Non Bank Financial Institutions
  • Firms
  • Central Banks

6
The Forex Market features
  • Huge and growing volume of transactions
  • Dollar dominated
  • Takes place in major financial centers
  • Efficient, low transactions costs

7
Types of transactions
  • Spot
  • Forward and futures contracts
  • Swaps
  • Options

8
Why Forward Contracts May be useful
  • Suppose that you are going to receive or have to
    make a foreign currency payment in the future.
  • Without a forward contract, the dollar value of
    that payment can go up or down
  • With a forward contract, the dollar value can be
    locked today.

9
Why options may be useful
  • Suppose you may, or may not, receive a foreign
    currency payment in the future.
  • You can buy a put option, which gives you the
    right, but not the obligation, to sell the
    foreign exchange if and when you receive the
    payment

10
The Demand for Domestic and Foreign Currency
Deposits
  • Rate of return definition
  • Real versus nominal rates of return.
  • Computing the dollar rate of return in a foreign
    currency deposit

11
  • The dollar rate of return on a Euro deposit is,
    approximately, the interest rate on Euro deposits
    plus the expected rate of depreciation of the
    dollar against the Euro

12
Interest parity
  • We will assume that
  • i i (e-e)/e
  • where i interest rate on domestic currency
    deposits
  • i interest rate on foreign currency deposits
  • e current exchange rate
  • e future expected exchange rate

13
Why is IP a good assumption
  • If it does not hold, the dollar expected return
    on dollar deposits would be different from the
    dollar expected return on foreign currency
    deposits
  • People would switch from one kind to the other,
    causing the spot exchange rate to adjust.

14
Expected Returns on Euro Deposits when Ee/
1.05 Per Euro
15
The Current Exchange Rate and the Expected
Return on Dollar Deposits
16
The Current Exchange Rate and the Expected Return
on Dollar Deposits
17
Determination of the Equilibrium Exchange Rate
18
The Market for Foreign Exchange
  • The effects of changing interest rates
  • an increase in the interest rate paid on deposits
    denominated in a particular currency will
    increase the rate of return on those deposits.
  • This leads to an appreciation of the currency.
  • A rise in dollar interest rates causes the dollar
    to appreciate.
  • A rise in euro interest rates causes the dollar
    to depreciate.

19
The Effect of a Rise in the Dollar Interest Rate
20
The Effect of a Rise in the Euro Interest Rate
21
The Effect of an Expected Appreciation of the
Euro
People now expect the euro to appreciate
22
The Effect of an Expected Appreciation of the
Euro (cont.)
  • If people expect the euro to appreciate in the
    future, then investment will pay off in a
    valuable (strong) euro, so that these future
    euros will be able to buy many dollars and many
    dollar denominated goods.
  • the expected return on euros therefore increases.
  • an expected appreciation of a currency leads to
    an actual appreciation (a self-fulfilling
    prophecy)
  • an expected depreciation of a currency leads to
    an actual depreciation (a self-fulfilling
    prophecy)

23
Covered Interest Parity
  • Covered interest parity relates interest rates
    across countries and the rate of change between
    forward exchange rates and the spot exchange
    rate
  • R R (F/ - E/)/E/
  • where F/ is the forward exchange rate.
  • It says that rates of return on dollar deposits
    and covered foreign currency deposits are the
    same.
  • How could you make easy, risk-free money in the
    foreign exchange markets if covered interest
    parity did not hold?
  • Covered positions using the forward rate involve
    little risk.

24
Summary
  • Exchange rates are prices of foreign currencies
    in terms of domestic currencies, or vice versa.
  • Depreciation of a countrys currency means that
    it is less expensive (valuable) and goods
    denominated in it are less expensive exports are
    cheaper and imports more expensive.
  • A depreciation will hurt consumers of imports but
    help producers of exports.

25
Summary (cont.)
  • Appreciation of a countrys currency means that
    it is more expensive (valuable) and goods
    denominated in it are more expensive exports are
    more expensive and imports cheaper.
  • An appreciation will help consumers of imports
    but hurt producers of exports.
  • Commercial banks that invest in deposits of
    different currencies dominate the foreign
    exchange market.
  • Expected rates of return are most important in
    determining the willingness to hold these
    deposits.

26
Summary (cont.)
  • Returns on bank deposits in the foreign exchange
    market are influenced by interest rates and
    expected exchange rates.
  • Equilibrium in the foreign exchange market occurs
    when returns on deposits in domestic currency and
    in foreign currency are equal interest rate
    parity.
  • An increase in the interest rate on a currencys
    deposit leads to an increase in the rate of
    return and to an appreciation of the currency.

27
Summary (cont.)
  • An expected appreciation of a currency leads to
    an increase in the expected rate of return for
    that currency, and leads to an actual
    appreciation.
  • Covered interest parity says that rates of return
    on domestic currency deposits and covered
    foreign currency deposits using the forward
    exchange rate are the same.
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